Austrian business cycle theory

Economic theory

The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in Economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory. According to the theory, the business cycle unfolds in the following way: low interest rates tend to stimulate borrowing, which lead to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit sourced boom results in widespread malinvestment. A correction or credit crunch, commonly called a "recession" or "bust", occurs when the credit creation has run its course. The money supply then contracts (or its growth slows), causing a curative recession and eventually allowing resources to be reallocated back towards their former uses. The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists on both theoretical and empirical grounds. Austrian School theorists have continued to contest these conclusions.

According to ABCT, in a genuinely free market random bankruptcies and business failures will always occur at the margins of an economy, but should not "cluster" unless there is a widespread mispricing problem in the economy that triggers simultaneous and cascading business failures. According to the theory a period of widespread and synchronized "malinvestment" is caused by mis pricing of interest rates thereby causing a period of widespread and excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt. The initial expansion is believed to be caused by fractional reserve banking encouraging excessive lending and borrowing at interest rates below what full reserve banks would demand. Due to the availability of relatively inexpensive funds, entrepreneurs invest in capital goods for more roundabout, "longer process of production" technologies such as “high tech” industries. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to “high tech” capital goods rather than basic consumer goods such as food. However, such a shift is inevitably unsustainable over time due to mispricing caused by excessive credit creation by the banks and must reverse itself eventually as it is always unsustainable. The longer this distorting dislocation continues, the more violent and disruptive will be the necessary re adjustment process. Austrian School theorists argue that a boom taking place under these circumstances is actually a period of wasteful malinvestment. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank lending causes a generalized speculative investment bubble which is not justified by the long term factors of the market. The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires. The monetary boom ends when bank credit expansion finally stops, i. e. when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. The longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures, and depression readjustment. More government or private debt solving a debt related problem is logically impossible.

Austrian School theorists generally argue that inherently damaging and ineffective central bank policies, including unsustainable expansion of bank credit through fractional reserve banking, are the predominant cause of most business cycles, as they tend to set artificial interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings. Under fiat monetary systems, a central bank creates new money when it lends to member banks, and this money is multiplied many times over through the money creation process of the private banks. This new bank created money enters the loan market and provides a lower rate of interest than that which would prevail if the money supply were stable.

A similar theory appeared in the last few pages of Mises's The Theory of Money and Credit (1912). This early development of Austrian business cycle theory was a direct manifestation of Mises's rejection of the concept of neutral money and emerged as an almost incidental by product of his exploration of the theory of banking. David Laidler has observed in a chapter on the theory that the origins lie in the ideas of Knut Wicksell. Nobel laureate Hayek's presentation of the theory in the 1930s was criticized by many economists, including John Maynard Keynes, Piero Sraffa and Nicholas Kaldor. In 1932, Piero Sraffa argued that Hayek's theory did not explain why "forced savings" induced by inflation would generate investments in capital that were inherently less sustainable than those induced by voluntary savings. Sraffa also argued that Hayek's theory failed to define a single "natural" rate of interest that might prevent a period of growth from leading to a crisis. Hayek reformulated his theory in response to those objections. Austrian School economist Roger Garrison explains the origins of the theory: Grounded in the economic theory set out in Carl Menger's Principles of Economics and built on the vision of a capital using production process developed in Eugen von Böhm Bawerk's Capital and Interest, the Austrian theory of the business cycle remains sufficiently distinct to justify its national identification. But even in its earliest rendition in Mises's Theory of Money and Credit and in subsequent exposition and extension in F. A. Hayek's Prices and Production, the theory incorporated important elements from Swedish and British economics. Knut Wicksell's Interest and Prices, which showed how prices respond to a discrepancy between the bank rate and the real rate of interest, provided the basis for the Austrian account of the misallocation of capital during the boom. The market process that eventually reveals the intertemporal misallocation and turns boom into bust resembles an analogous process described by the British Currency School, in which international misallocations induced by credit expansion are subsequently eliminated by changes in the terms of trade and hence in specie flow. Ludwig von Mises and Friedrich Hayek were two of the few economists who gave warning of a major economic crisis before the great crash of 1929. In February 1929, Hayek warned that a coming financial crisis was an unavoidable consequence of reckless monetary expansion. Austrian School economist Peter J. Boettke argued in the wake of the Great Recession that the Federal Reserve was making a mistake by not allowing consumer prices to fall. According to him, the Fed's policy of reducing interest rates to below market level when there was a chance of deflation in the early 2000s together with government policy of subsidizing homeownership resulted in unwanted asset inflation. Financial institutions leveraged up to increase their returns in the environment of below market interest rates. Boettke further argues that government regulation through credit rating agencies enabled financial institutions to act irresponsibly and invest in securities that would perform only if the prices in the housing market continued to rise. However, once the interest rates went back up to the market level, prices in the housing market began to fall and soon afterwards financial crisis ensued. Boettke attributed the failure to policy makers who assumed that they had the necessary knowledge to make positive interventions in the economy. The Austrian School view is that government attempts to influence markets prolong the process of needed adjustment and reallocation of resources to more productive uses. In this view bailouts serve only to distribute wealth to the well connected, while long term costs are borne out by the majority of the ill informed public. Economist Steve H. Hanke identifies the 2007–2010 global financial crises as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by the Austrian business cycle theory. Financial analyst Jerry Tempelman has also argued that the predictive and explanatory power of ABCT in relation to the global financial crisis has reaffirmed its status and perhaps cast into question the utility of mainstream theories and critiques.

Empirical economic research findings are inconclusive, with different economic schools of thought arriving at different conclusions. In 1969, Nobel laureate Milton Friedman found the theory to be inconsistent with empirical evidence. Twenty five years later in 1993, he reanalyzed the question using newer data, and reached the same conclusion. However, in 2001, Austrian School economist James P. Keeler argued that the theory is consistent with empirical evidence. Economists Francis Bismans and Christelle Mougeot arrived at the same conclusion in 2009. According to some economic historians, economies have experienced less severe boom bust cycles after World War II, because governments have addressed the problem of economic recessions. Many have argued that this has especially been true since the 1980s because central banks were granted more independence and started using monetary policy to stabilize the business cycle, an event known as The Great Moderation. However, Austrian economists argue the opposite, that boom bust cycles following the creation of the Federal Reserve have been more frequent and more severe than those prior to 1913.

According to Nicholas Kaldor, Hayek's work on the Austrian business cycle theory had at first "fascinated the academic world of economists" but attempts to fill in the gaps in theory led to the gaps appearing "larger, instead of smaller" until ultimately "one was driven to the conclusion that the basic hypothesis of the theory, that scarcity of capital causes crises, must be wrong". Lionel Robbins, who had embraced the Austrian theory of the business cycle in The Great Depression (1934), later regretted having written that book and accepted many of the Keynesian counterarguments. The Nobel Prize Winner Maurice Allais was a proponent of Austrian business cycle theory and their perspective on the Great Depression and often quoted Ludwig Von Mises and Murray N. Rothbard. When, in 1937, the League of Nations examined the causes of and solutions to business cycles, the Austrian business cycle theory alongside the Keynesian and Marxian theory were the three main theories examined.

The Austrian theory is considered one of the precursors to the modern credit cycle theory, which is emphasized by Post Keynesian economists, economists at the Bank for International Settlements. These two emphasize asymmetric information and agency problems. Henry George, another precursor, emphasized the negative impact of speculative increases in the value of land, which places a heavy burden of mortgage payments on consumers and companies. A different theory of credit cycles is the debt deflation theory of Irving Fisher. In 2003, Barry Eichengreen laid out a credit boom theory as a cycle in which loans increase as the economy expands, particularly where regulation is weak, and through these loans' money supply increases. However, inflation remains low because of either a pegged exchange rate or a supply shock, and thus the central bank does not tighten credit and money. Increasingly speculative loans are made as diminishing returns lead to reduced yields. Eventually inflation begins or the economy slows, and when asset prices decline, a bubble is pricked which encourages a macroeconomic bust. In addition, White believes that the Austrian explanation of the business cycle might be relevant once again in an environment of excessively low interest rates. According to the theory, a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. Joseph Salerno, Peter G. Klein have testified before Congressional Committee about the beneficial results of moving to either a free banking system or a free full reserve banking system based on commodity money based on insights from Austrian business cycle theory.

Jeffery Rogers Hummel argues that the Austrian explanation of the business cycle fails on empirical grounds. In particular, he notes that investment spending remained positive in all recessions where there are data, except for the Great Depression. He argues that this casts doubt on the notion that recessions are caused by a reallocation of resources from industrial production to consumption, since he argues that the Austrian business cycle theory implies that net investment should be below zero during recessions. In 1969, economist Milton Friedman, after examining the history of business cycles in the U. S., concluded that the Austrian Business Cycle was false. Referring to Friedman's discussion of the business cycle, Austrian economist Roger Garrison stated that "Friedman's empirical findings are broadly consistent with both Monetarist and Austrian views" and goes on to argue that although Friedman's model "describes the economy's performance at the highest level of aggregation; Austrian theory offers an insightful account of the market process that might underlie those aggregates".